What is terminal value in a DCF?

In a discounted cash flow valuation, analysts usually forecast cash flows for five to ten years. But companies can last much longer. Terminal value captures everything after the forecast period. This page explains what it is, how it is calculated and why it needs care.

Quick answer

Terminal value is the estimated value of a business's cash flows beyond the explicit forecast period in a DCF valuation, expressed as a single amount at the end of that period. It is usually calculated with the perpetuity growth (Gordon growth) method or the exit multiple method. Terminal value often makes up more than half of a company's total DCF value, so its assumptions matter a lot.

Key takeaways

• It captures value beyond the forecast period.
• Two main methods: perpetuity growth and exit multiple.
• It often makes up more than half of DCF value.
• Long-term growth should not exceed long-run economic growth.
• It must be discounted back to today's value.

Why do we need terminal value?

In a discounted cash flow valuation, forecasting cash flows year by year for decades is not practical. So analysts forecast in detail for a limited period, say ten years, and then assume the business settles into a steady state. A single number represents all cash flows after that point.

Without it, a DCF would ignore most of a long-lived company's value. With it, the model includes the business as an ongoing concern.

Method 1: Perpetuity growth

This method, also called the Gordon growth approach, assumes cash flows grow at a constant rate forever after the forecast period. The formula is: Terminal value = Final year cash flow x (1 + g) / (r minus g), where g is the long-term growth rate and r is the discount rate.

For example, if the final forecast year's free cash flow is Rs 100 crore, g is 5 percent and r is 11 percent, the terminal value is 100 x 1.05 / 0.06, which is Rs 1,750 crore at the end of the forecast period.

Method 2: Exit multiple

This method assumes the business could be sold at the end of the forecast period at a multiple similar to peers, such as EV/EBITDA. If final-year EBITDA is Rs 200 crore and a multiple of 10 times is used, the terminal value is Rs 2,000 crore.

Why terminal value needs care

Because it often makes up 60 to 80 percent of the total value in many DCF models, small changes in its inputs can swing the final answer a lot. For example, raising long-term growth from 5 to 6 percent in the example above lifts the figure from Rs 1,750 crore to Rs 2,120 crore.

A sensible rule is that perpetual growth should not exceed the long-run growth of the economy, since no company can grow faster than the economy forever. Analysts often run both methods and compare the results as a check.

Do not forget to discount it

The terminal value is calculated as of the end of the forecast period. It must be discounted back to today using the same discount rate as the other cash flows, before adding it to the total.

In short, it represents the long future of a business in one number. It is necessary in a DCF, but it is also where the biggest assumptions hide.

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